COLLEGE SAVINGS 101

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529 E-ditorials

03-1: 529 R.I.P.?
Joe Hurley
Sunday, February 9th 2003

President Bush’s proposal for the Lifetime Savings Account (LSA), contained in the 2004 Budget released on February 3, 2003, is clearly causing a tremor in the college savings marketplace. What will happen to 529 plans…to Coverdell ESAs…or to Savingforcollege.com, for that matter?

The LSA is a new tax incentive for savings, without the usual strings attached. Through a financial institution, everyone, regardless of age or income, will be able to make up to $7,500 in annual cash contributions to an LSA, investing in CDs, mutual funds, or other securities offered by the institution. Earnings will accumulate federal tax-free in your LSA, and you will be allowed to take withdrawals at any time and for any purpose without incurring federal income tax.

You will also be able to fund your child’s, grandchild’s, and anyone else’s LSA to the extent they have room under their own $7,500 contribution caps. Of course, your contribution to someone else’s LSA is subject to gift tax. An LSA for a minor becomes his or her property at age 18. You will be able to shift LSA funds among family members, subject to gift-tax consequences.

Simple, tax-free savings for everyone. Useful for college and any other purpose. No requirement to take withdrawals within a certain period of time. Sound too good to be true? (The Bush proposal contains several other major items, including a replacement for the Roth IRA called the Retirement Savings Account, or RSA, and a consolidation of employer-based retirement savings accounts into the Employer Retirement Savings Account, or ERSA.)

Let’s take a closer look. What does the LSA proposal really mean for college savers, and for 529 plans?

It’s a long way from here to enactment.

Making new tax law is an uncertain and often mysterious process. Already, objections are being raised over the impact of the Bush proposals on the federal budget deficit, and the inevitable issues surrounding taxpayer fairness are likely to follow. If anything ever comes of the LSA, the end result may look much different than the original design. One mid-1990s push for a powerful, new education savings account ultimately turned into the anemic, penalty-prone $500 Education IRA. Every year, bills are introduced in Congress to abolish the Internal Revenue Code, and, of course, that never happens. Even the best intentions easily become waylaid.

The LSA won’t be as simple as advertised.

“No longer will people have to worry about the endless maze of confusing rules,” says Treasury Assistant Secretary for Tax Policy Pamela Olson. Not quite, say I.

The end to the simplicity begins with the realization that the LSA will not replace the existing tax-favored programs that are viewed by many (including me) as complicated. Coverdell education savings accounts, 529 plans, savings bonds, and IRAs will continue to function as investments with special tax benefits when used for qualified education expenses.

Certain questions will have to be addressed. For example, will you be permitted to withdraw tax-free from your LSA and use those funds to produce a Hope credit, a Lifetime Learning credit, or some other tax benefit? The tax law is usually written to prevent “double-dipping,” and these so-called coordination provisions can be tricky and confusing.

What about losses? As we all know now, your investments may decrease in value. Will you be allowed to take a tax deduction for an LSA closed out with a loss? If so, you will need to maintain “basis” records under a complex set of tax accounting rules.

Then there are the inevitable loophole-plugging rules. With anything this good, there are bound to be unintended tax-planning opportunities. Either Congress will have to anticipate these strategies, or the IRS will have to impose its own set of rules and restrictions.

529 plans will still be useful to many investors.

The LSA will not permit you to remove large amounts of assets from your estate and retain full control over those assets. Only the 529 plan offers this benefit, so it will continue to offer an advantage for any parent or grandparent who has to worry about estate taxes. Also consider that, at $7,500 annually, an LSA may be inadequate for those families with the means, and the desire, to save for the full cost of undergraduate and graduate degrees.

Prepaid tuition plans run by the states (and soon by private schools) will continue to attract many families who prefer tuition inflation protection over a traditional investment vehicle.

The Coverdell education savings account (ESA) will become obsolete with the LSA in place. I can see no reason why anyone would prefer the ESA.

The states will not capitulate.

Many states permit contributions into their 529 plans to be deducted from state income tax. Some offer scholarships or matching contributions to families enrolled in their 529 plans. You won’t get those benefits with an LSA. Furthermore, I suspect that a number of states will decide not to follow federal tax-free treatment of LSAs, and will impose tax on their residents withdrawing earnings from an LSA. After all, the LSA is direct competition for their 529 plans and the states have a vested interest in keeping their programs healthy. Not only will the state-level differences impact your investment decision, they will also greatly complicate the tax-preparation process.

What do you do now?

I see no reason to change your current college savings strategy in the face of the President’s proposal. If the LSA makes it through Congress intact, you will be allowed to convert your 529 plan and ESA balances to an LSA anytime before the end of this year without federal income tax. In fact, some investors will seek to put as much money into their 529 accounts as possible, anticipating that the 2003 conversion option will not be subject to the $7,500 LSA contribution cap.

One can never be sure, but when all is said and done, I believe the LSA will be something less than what has been proposed, 529 plans will remain popular, and the tax law will stay just as complicated as it is now.

And I expect that Savingforcollege.com will still be around doing what we’ve always been doing: trying to help you.